Smart Tax Planning Tips for the Small S Corporation

Recent Internal Revenue Service data show that S corporations represent the most popular form of incorporation. That's understandable. S corporations often save lots of tax for small businesses.

Unfortunately, the S corporation's extra accounting complexity sometimes means that small business owners don't get all the savings they're legally entitled to. To guarantee that you don't lose any tax savings, follow these tips:

Tip #1: Set a Reasonable But Low Salary

S corporation profits get paid out to the business owners either in the form of salary or profits. In other words, an S corp owner typically receives two types of checks from the business: payroll checks representing wages and dividend checks representing a share of the business profits.

The most important thing an S corporation can do to minimize the tax burden shouldered by the owners is pay shareholder-employees a low though reasonable salary. Here's why: Paying out profit as wages subjects that money to Social Security taxes and Medicare taxes. In comparison, paying out profits as dividends doesn't subject the money to Social Security and Medicare taxes.

Example: An S corporation that makes, say, $100,000 in profit before paying wages or salary to the owner would pay roughly $15,000 in Social Security and Medicare taxes if all the profit is paid out as wages or salary. If only $50,000 is paid as wages, however, the corporation reduces the Social Security and Medicare tax bill from $15,000 to $7,500.

Tip #2: Minimize Distributions

When a small business makes the election to have a corporation or limited liability company treated as an S corporation--both corporations and LLCs can be treated as S corps--the IRS warns about setting shareholder-employee wages too law. That warning also alerts the business about what happens when the salary does happen to be set too low: The IRS can re-classify distributions, or dividends, paid to shareholders as salaries or wages.

Note: Business owners commonly call the distributions of profit paid out to S corporation shareholders "dividends." However, to be nitpicky, under the corporate tax law rules, dividends typically get paid by regular C corporations rather than by by S corporations. S corporations (and partnerships, too) make "distributions" of the profit. But back to the tip of minimizing distributions...

The IRS ability to re-categorize distributions as wages means that, to the extent possible, you may as well minimize distributions of profit to shareholders. In other words, don't distribute money to shareholders simply because you can. For example, if shareholders will save the money (say for working capital purposes or for a new business investment), just save the money inside the S corporation--not outside the corporation.

Example: If a corporation makes a $100,000 profit and pays out half of this money, or $50,000 as wages and the other half or $50,000 as distribution, the IRS may be able to re-categorize some or all of the $50,000 distribution as wages. If the corporation pays only a $30,000 distribution, in the worst-case scenario the IRS can probably only reclassify the $30,000 as wages.

In the end, by minimizing distributions, the S corporation minimizes the money that can theoretically be reclassified as shareholder-employee wages.

Tip #3: Move Deductions to the S Corporation Tax Return

A final easy tip can often be employed by the small business corporation using the Subchapter S rules. You can often move tax deductions from the shareholder's 1040 tax return to the corporation's 1120S corporation tax return.

Moving deductions from an individual tax return to the corporation tax return may not save the shareholder-employee and S corporation owner income taxes. Afterall, the deduction represents a deduction on both tax returns. But the benefit of moving a tax deduction to the corporation return is that deduction then naturally reduces the distributions made to shareholders.

Example: Suppose an S corporation makes $100,000 in profits before paying the shareholder-employee wages. Further suppose that the shareholder-employee purchases individual health insurance for his family at an annual cost of $10,000, annually saves $5,000 for retirement and makes $5,000 annual charitable contributions. If these deductions are paid by the corporation rather than by the individual, the shareholder finds himself in the same economic position. But now the S corporation is paying out $80,000 in wages and distributions to the shareholder-employee rather than $100,000.


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Author, accountant and former tax professor Stephen L. Nelson specializes in provding tax planning and preparation services to S corporations. Nelson is also the author of do-it-yourself guides for Setting up a Florida S corporation and for Setting up a Georgia S corporation.